King v. Burwell: Fix Obamacare’s Job Killing Tax Credits

(A versio30-ways-to-cut-your-health-care-costsn of this Health Alert was published by Forbes.)

You read that headline right: It is not only those who pay Obamacare taxes who suffer, but those who receive them. That’s because the tax credits are calculated so perversely that people who receive them actually get punished for working more hours. In the wake of the Supreme Court’s forthcoming decision on King v. Burwell, which will determine whether tax credits paid in at least 34 states are legal, fixing this should be a priority for Congress and President Obama.

For the first time since 2012, the Congressional Budget Office has done a comprehensive estimate of the costs and benefits of Obamacare. The new estimate concludes that repealing Obamacare would increase Gross Domestic Product by 0.7 percent over the next ten years. The primary reason is the disincentive to work contained in the design of the tax credits.

Of course, President Obama is not going to repeal Obamacare. Nevertheless, in the wake of King v. Burwell, much of this problem can be alleviated without doing violence to the president’s goal of increasing coverage, as I describe in a new study from the National Center for Policy Analysis (NCPA).

Notches and cliffs are terms used to describe the effect of large changes in tax rates over small ranges of income. Obamacare’s notches and cliffs are best illustrated using the Kaiser Family Foundation’s Health Insurance Marketplace Calculator. For a family of four, with two 35-year-old (nonsmoking) parents and two children, $23,850 is their household income at 100 percent of the Federal Poverty Level (FPL), which is the lower bound of the income range to claim Obamacare tax credits that reduce premium.

If the household income were $23,850, the family’s maximum annual premium would be $479 (2.01 percent of $23,850), so it would benefit from a tax credit paid to its health insurer of $9,146 ($9,625 minus $479).  If the family’s income rose to $31,720, its maximum annual premium would be $638, so its tax credit would go down to $8,987. The household income has increased by $7,870, and its tax credit has dropped by $159. Effectively, the household has experienced an income tax rate of 2.01 percent ($159 divided by $7,870).

However, when household income increases by one dollar from $31,720 to $31,721, the household is liable to pay 3.02 percent of household income ($958) for the same plan. For an increase of one dollar of income, the household net premium increases by $320 (from $638 to $958), resulting in a net loss of $319 and an effective marginal income tax of 32,000 percent!

The net effect of the income increase and the premium increase does not balance until the household income reaches $32,097 (at which point the increase in both income and premium is $359).

Few would seek to work more hours if it resulted in no net increase in take-home pay. A 15 percent income increase results in a marginal income tax rate of 18 percent ($878 increase in premium divided by $4,758 increase in income). At that tax rate, it is reasonable to conclude the extra work might be worth the effort. However, it is not that easy for people to just increase their hours by 15 percent. This perverse effect riddles Obamacare’s tax credits all the way up to 400 percent of FPL. It may be the most important reason for the stagnation of work among hourly employees.

A reform that would reduce Obamacare’s disincentive to work consists of reducing a fixed share of the tax credit for every dollar increase in income (which would effectively be a flat rate of income tax). My NCPA study demonstrates this by using a simple illustration of households bounding the range within which tax credits are currently paid. The $23,850 household receives a tax credit of $9,654, which is actually $508 more than it receives under Obamacare. The tax credit phases out at a rate of 13.49 percent. That is, every $100 increase in household income would result in a decrease of $13.49 in tax credit. There are no “notches” or “cliffs”: It is a straight line. Relative to Obamacare, everybody wins because nobody has an incentive to limit his working hours because of a reduction in take-home pay.

Further, this flat rate reform also satisfies a budget constraint. The total amount spent on tax credits for these households is exactly the same under both Obamacare and the flat rate reform.

This flat rate reform should be acceptable to both Republicans and Democrats, both of whom endorse means testing Medicare Part B and Part D premiums. This flat rate reform alone would result in no changes to Obamacare’s benefits with significantly positive effects on beneficiaries’ incentives to work.

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